Early Withdrawal Penalties – How to Keep More of Your Retirement Funds

Early withdrawal penalties have become a fact of life with a wide variety of investment vehicles. They are set up as a disincentive for people to make early withdrawals from certain time-sensitive account types. This includes everything from bank issued certificates of deposits to the various tax-sheltered retirement programs available. So how can you keep more of your retirement funds safe from early withdrawal penalties?

Before we dive into how to avoid these types of penalties, let's discuss the different kinds of investment accounts.

Certificates of Deposit (CDs)

When you open a CD, you’re entering into a contract with the bank to invest your money with them in a savings instrument that will pay a fixed rate of interest over a specified time. This is why CDs are referred to as time deposits.

The bank will make fixed rates available if they are able to match that deposit with corresponding loans, which are interest-earning assets of the bank. If you withdraw funds from your certificate ahead of schedule, it causes something of an income problem with the bank, hence the early withdrawal penalty.

A typical early withdrawal penalty on a CD will be equal to three month’s interest for certificates that mature in less than one year, or six month’s interest for certificates with maturities of one year or more. Some banks even charge more.

The only way to avoid an early withdrawal penalty on a CD is to purchase one from a bank that specifically excludes early withdrawal penalties on its time deposits. There are a few banks that don‘t, but the vast majority of banks do.

Traditional Individual Retirement Accounts (IRAs)

As a rule, any amounts withdrawn from an IRA before you turn 59 ½ are regarded by the IRS as early withdrawals, and subject not only to income tax, but also to the IRS 10% penalty tax for early withdrawals.

The penalty is assessed on any investment earnings, and on any contribution amounts that were tax-deductible when they were made. Nondeductible IRA contributions are not subject either to income tax or the early withdrawal penalty, since there was no tax advantage when the contributions were made.

There are exceptions to the early withdrawal penalty on traditional IRAs:

• Reaching age 59 ½
• Roll-overs between IRAs within 60 days
• Death of the account holder
• Total and permanent disability of the account holder
• Qualified higher education expenses
• A series of substantially equal payments from the account
• First time homebuyers, up to $10,000
• An IRS levy of the plan
• Un-reimbursed medical expenses greater than 10% of adjusted gross income (if under age 65)
• Health insurance premiums, if unemployed
• Certain distributions to qualified military reservists if called to active duty

Roth IRAs

Roth IRAs carry similar early withdrawal penalties to traditional IRAs, with one notable exception. Since contributions to a Roth IRA are not tax-deductible, those funds are not subject to either income tax or the 10% early withdrawal penalty. As such, the penalty applies strictly to the amount withdrawn from the plan that constitutes investment earnings.

And like traditional IRAs, there is a long list of exceptions to the early withdrawal penalty:

• Reaching age 59 ½, and as long as the plan has been in effect for at least five years
• Roll-overs between Roth IRAs within 60 days
• Death of the account holder
• Total and permanent disability of the account holder
• Qualified higher education expenses
• A series of substantially equal payments from the account
• To buy, build or rebuild a first home
• Un-reimbursed medical expenses greater than 10% of adjusted gross income (if under age 65)
• Health insurance premiums, if unemployed
• Certain distributions to qualified military reservists if called to active duty

401(k) Withdrawals

Any amount of money withdrawn early from a 401(k) plan will be subject to both income tax and the IRS 10% early withdrawal penalty. This is because all contributions to a 401(k) plan are tax-deductible when made, and all investment income earned is tax-deferred.

And once again, the IRS provides a long list of exemptions to the early withdrawal penalty in the case of 401(k)s:

• Reaching age 59 ½
• Roll-overs between 401(k) plans within 60 days
• Death of the account holder
• Total and permanent disability of the account holder
• Pursuant to a Qualified Domestic Relations Order (QDRO)
• A series of substantially equal payments from the account
• An IRS levy of the plan
• Un-reimbursed medical expenses greater than 10% of adjusted gross income (if under age 65)
• Certain distributions to qualified military reservists if called to active duty
• Separation from service during or after the year the employee reaches age 55, or age 50 for public safety employees in a governmental defined benefit plan

The rules in regard to taking early distributions from any retirement plan can be complicated. Be sure to consult your tax advisor before making any withdrawals.

Before withdrawing funds from your retirement accounts early, make sure you understand the ins-and-outs of how to save more of your money.

(Source for retirement penalties: Retirement Topics – Exceptions to Tax on Early Distributions and IRS Publication 590)